Articles

The Sum Vs. The Parts
By Craig Israelsen

Page 1 of 5

[Note: This article is expanded from the print version.]

I've come to believe that the active vs. passive debate is not really influenced much by "facts," inasmuch as either side of the issue can point to studies that vindicate their opinion. There is, however, an element - an important "fact" - of the debate that seems to be missing: the performance comparison between active vs. passive investing at the portfolio level.

The vast majority of active/passive studies focus on how a certain group of comparable actively managed funds have fared against some relevant benchmark index or index fund (most often the S&P 500). While that is of interest, it necessarily involves studying the passive asset (a passively managed index fund) and the active asset (an actively managed fund) outside of their natural habitat-which is inside a portfolio of several funds. Whether or not the Vanguard 500 Index fund outperforms "x" percent or "y" percent of actively managed U.S. equity large-cap blend funds is only part of the issue. The whole of the issue is how well a portfolio of passively managed index funds performs in comparison to a portfolio of comparable actively managed funds.

Having said that, it may be that comparing the performance of actively managed funds against the performance of index funds is inherently inequitable, inasmuch as they are simply different products. Index funds attempt to mimic (to a greater or lesser degree) a given index. Actively managed funds have greater latitude in the number and types of assets (stocks, bonds, convertibles, preferred stock, cash, etc.) they can invest in. Thus, comparing active vs. passive investing may be similar to comparing two guitarists, where one is following the sheet music and the other is improvising. Are they really comparable? Maybe yes, maybe no. It's hard to say. Nevertheless, active vs. passive comparisons will continue into the foreseeable future. Therefore, this article suggests that such comparisons take into account the performance of the whole portfolio rather than simply the performance of the separate portfolio parts.

We examined the performance of a portfolio of four index funds in comparison with a portfolio of four actively managed funds, using aggregated performance data for the active funds. This approach is much like studying the behavior of family members within their family setting, rather than studying each person in isolation.

The data for this study were obtained from Morningstar Principia. The four index funds chosen to represent a "passive portfolio" were funds tracking the Vanguard 500 Index, Vanguard Extended Market Index, Vanguard Total International Stock Index and Vanguard Total Bond Index. Index funds, rather than raw indexes, were chosen for use in this study inasmuch as raw indexes are not purchasable, whereas index funds are. Moreover, raw indexes do not have expense ratios, which is an unrealistic assumption in the real world of actual products purchased by actual investors.

The Vanguard 500 Index fund (VFINX) tracks the Standard & Poor's 500 Index, which represents the performance of the largest companies in the U.S. market.

The Extended Market Index fund (VEXMX) tracks the S&P Completion Index, which is comparable to the Dow Jones Wilshire 4500 - both of which track the performance of mid- and small-cap stocks that fall outside the scope of the S&P 500. The best-fit index for VEXMX in the Morningstar Principia database is the DJ Wilshire 4500 Index.

The Vanguard Total International Stock Index fund (VGTSX) is comprised of three Vanguard funds (Pacific Stock Index, European Stock Index and Emerging Markets Stock Index). The bulk of the fund tracks the MSCI EAFE (Euro p e , Australasia, and Far East) Index, while a portion of it attempts to track the MSCI Emerging Markets Index. Its best-fit index within Morningstar Principia is the Morgan Stanley World xUS Index (i.e., world stock minus U.S. Stock).

Vanguard's Total Bond Index fund (VBMFX) attempts to mimic the performance of the Lehman Brothers Aggregate Bond Index, which not surprisingly is also its best-fit index in the Morningstar database.